Risk management is one of the most important skills Forex traders can learn, and it’s a useful skill throughout the trader’s entire career. The reason is simple. Proper risk management ensures traders can withstand losing streaks and protect themselves against losses. Without it, the trader is essentially gambling.
Many beginning Forex traders do not fully comprehend risk management because it is such a complex subject. Yet there are two useful measures of risk management that every trader should know: Drawdown and risk-reward ratio. If a novice trader can calculate these two items, they’re much more likely to sustain their accounts over a longer period of time.
What Is Drawdown in Forex Trading?
Every trader experiences losing streaks, and no Forex trading system offers 100-percent profitability. Loses are inevitable. For example, in 100 trades with a trading system with 80-percent profitability, the trader might lose 20 traders in a row before winning the final 80. A 20-loss streak can be problematic without proper risk management.
Drawdown is widely used to quantify the risk of a particular system. In the simplest terms, drawdown is the largest loss a trader could expect over the system’s maximum losing streak. If the trader’s account balance was $50,000 and he lost $25,000 during the system’s longest losing streak, the drawdown would be 50 percent. This is the amount you stand to risk by trading with a specific strategy.
Traders can minimise drawdown by limiting the amount they risk on each trade. In the Forex industry, traders are often encouraged to limit risk to 2-percent of their account balance per trade. Losses add up quickly when using more than 2-percent risk. To illustrate, suppose a trader has an account balance of $20,000. If they went on a 10-loss losing streak and risked 2 percent on each trade, the remaining balance would be $16,675. Using 10-percent risk, the balance would be just over $7,500 over that same 10-loss period. That’s a difference of nearly $10,000!
Calculating Risk-Reward Ratio in Forex
In addition to limiting exposure on each trade, there’s another risk management measure traders should utilise. It’s the risk-reward ratio of a specific trade, which is the amount that can be won or lost per trade. Risk-reward ratio should be about 3:1, especially for beginners. This means that the potential profits of a specific trade are 3 times as much as the potential losses.
Using a 3:1 risk-reward ratio, the trader can still turn a profit with a trading system that loses 50 percent of the time. For example, if a trade had a chance of winning $600 or losing $200, the profits after winning half of a 10-trade period would be $2,000.
Although a 3:1 ratio is preferred, it’s not always possible and it’s not right for every trading style. Scalpers, for instance, tend to turn small profits off of each trade, and they often use much smaller ratios of 1:1 to ensure that they open positions consistently. Position traders, on the other hand, look to maximise risk-reward ratio for longer-term positions, and they might prefer to trade at a ratio of 10:1 or more.
Finally, risk-reward ratio is constantly adjusted by traders, based on market conditions, the trading timeframe, and the trader’s entry/exit strategy. But a 3:1 ratio is a reliable benchmark that can help new and intermediate Forex traders sustain profits and prevent losses from stacking up.
In summary, it’s clear why risk management is so critical in Forex trading. Without it, the trader’s losses can add up quickly and completely wipe out their accounts. Fortunately, risk management is fairly simple to grasp, and taking the time to learn it will pay off throughout your career.
Embarking on trading after 15 years as an entrepreneur and a marketing and business manager within the IT field, Brent Eaton is one of Learn to Trade most experienced traders and educators who has experienced first-hand the highs and lows of the stock market and Forex.
Bringing over 10 years of trading experience, and building his sustaining wealth through Learn To Trade methodologies, Brent has helped thousands of students learn about trading and improve their wealth strategy.